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October 12, 2012

Do New Fannie-Freddie Bonds Signal Return of Asset-Backed Securities?

Fannie and Freddie are unable to issue higher-yielding bonds because of Dodd-Frank; an exemption would create ‘risk-sharing’ bond market

Editor’s update: On Friday, Oct. 12, following the publication of this article, the CTFC issued a letter pledging it would take no enforcement actions regarding foreign exchange forwards and swaps through year-end pending the Treasury Secretary’s review of appeals for permanent relief.

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Dodd-Frank rules that took effect on Friday and meant to make the $648 trillion swaps market more transparent would also have the perverse effects of denying higher income to yield-starved investors and keeping taxpayers on the hook for mortgage losses.

That is why industry representatives of asset-backed securities are looking to the Commodity Futures Trading Commission (CFTC) to provide an exemption from rules that would render their bonds “commodity pools” subject to CFTC supervision effective Friday.

“I’d be shocked if [the exemption] didn’t happen,” said Robert Bostrom (left), a securities lawyer with SNR Denton in New York, who offered no prediction as to the precise timing of such a decision.

“The policy imperative is so strong,” Bostrom told AdvisorOne in an interview. “The administration, Congress, the private sector – everyone wants the risk of loss shifted to the private sector. The agencies are trying to do exactly what they’re being told to do by the administration and Congress, but they bump into the [Dodd-Frank] law.”

Bostrom, who has been credited with guiding Freddie Mac through the financial crisis as its former general counsel, says the Federal Housing Finance Agency has found a way to limit the role of government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac in the housing market through the issuance of risk-sharing bonds.

But embedded in these bonds are derivative instruments including interest-rate swaps that protect investors from funding-cost spikes.

Dodd-Frank rules intended to lower risk in the financial system would subject even these transactions to strict capital, margin, recordkeeping and trading requirements that make it uneconomic for Fannie Mae and Freddie Mac to issue bonds to the public.

Ironically, that would block the reduction in mortgage risk borne by taxpayers through Fannie and Freddie’s effective ownership of private mortgages.

Bostrom estimates that Fannie and Freddie are buying some 70% of U.S. mortgages, with Ginnie Mae, the Veterans Administration and the Federal Housing Administration buying another 20%. That leaves just 10% in the hands of private investors, mainly banks. For comparison, GSEs owned just 40% of mortgages in the 2007 market.

“The banks don’t have adequate capital to hold large amounts of mortgages on their balance sheets,” Bostrom says. “Basel III will make that worse.” That’s why bringing private investors into the market through risk-sharing bonds is so important, he says.

“It’s such a critical policy initiative of the government and Congress to transfer one portion of the housing market back to the private sector.” For the past five years, that burden has rested on the taxpayers’ backs.

“If there were ever proof that the economy needs government support when times are bad,” it’s the financial crisis, Bostrom says. “There has to be a backstop to support the market. Otherwise you’d have a complete collapse of the housing market. There’d be no mortgages.”

The securities lawyer says that, while GSEs are fulfilling a vital role today, broadly supported alternatives should be encouraged where possible. He cited “consumer groups” as the only parties that might potentially oppose increasing private investment in mortgages because the mechanics of opening up financing would initially result in “modestly higher” mortgage rates.

Aside from a CFTC exemption stating no enforcement actions will be taken against asset-backed securities holding swaps, Bostrom said the other key reform would be the Consumer Financial Protection Agency providing safe harbor protection for banks selling qualifying residential mortgages to private investors.

“The seller has to absorb 5% of the first loss if loans don’t satisfy whatever conditions are put into the regulations. To the extent that the conditions are interpretive and not absolutely certain, it leaves the seller in doubt,” he says.

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